How Does an HSA Work?

Updated: Oct. 6, 2020, 2:41 p.m.

A health savings account (HSA) is a tax-advantaged investment account you can contribute to if you have a high-deductible health insurance plan. Employers often offer HSAs for employees, but you can also open your own. Contributions are tax-deductible up to annual limits, and money can be withdrawn tax-free to cover qualifying medical expenses.

Money in an HSA can be invested and can be withdrawn for any purpose after age 65 without penalty, although you’ll be taxed at your ordinary income-tax rate for distributions not used for covered medical costs.

Did you know?

You can use your HSA money, tax-free, to cover qualifying medical expenses.

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HSAs are unique for several key reasons:

  • You’re eligible to contribute only if you have a qualifying high-deductible health plan.
  • Your employer can open an HSA for you (and contribute money on your behalf), or you can open your own and make contributions to it.
  • Money can be invested and can grow for as long as you’d like; there’s no requirement to withdraw funds at any point. With most other tax-advantaged accounts -- including 401(k)s and traditional IRAs -- you’re subject to required minimum distributions (RMDs) after age 72.
  • HSA funds can be withdrawn tax-free at any age to cover qualifying medical expenses. With 401(K)s and IRAs, money can’t be withdrawn before age 59½ without a 10% penalty unless you qualify for a hardship distribution -- and you’re always taxed at your ordinary income tax rate on 401(k) or IRA distributions.
  • HSA funds withdrawn for purposes other than covering qualified medical expenses are subject to a 20% tax penalty. This is double the penalty that applies for early 401(k) or IRA withdrawals. However, it applies only until age 65, after which you can withdraw funds from an HSA for any purpose. In this case you’ll just pay ordinary income tax if the money isn’t used for healthcare.

How does an HSA work?

Health savings accounts can function as an important savings vehicle. They both make it easier to afford medical care and can help you save for retirement. However, there are rules you have to follow -- including restrictions on eligibility as well as annual contribution limits.

The rules applicable to health savings accounts are very different from those that apply to flexible spending accounts (FSAs), although both enable you to pay for medical care with pre-tax funds.

Who can contribute to a HSA?

As long as you have a qualifying high-deductible health plan and you don’t have any other insurance with a deductible below the limits (such as Medicare coverage), you can contribute to an HSA. The definition of a high-deductible plan varies from year to year, but the plan must meet two requirements:

  • Your deductible must equal or exceed a certain dollar amount.
  • Your plan must have an out-of-pocket maximum below a specific threshold.

The chart below shows the minimum annual deductible and maximum annual out-of-pocket costs for a qualifying high-deductible health plan in 2020. Eligibility is determined annually, so if your plan adheres to the restrictions in 2020 but you don’t meet the requirements in 2021, you can contribute in 2020 but not in the following year.

Data source: IRS
Qualification Self-Only Health Coverage Family Health Coverage
Annual deductible (minimum) $1,400 $2,800
Annual out-of-pocket costs (maximum) $6,900 $13,800

Annual contribution limits

You’re also limited in the amount you can contribute to an HSA each year, with the limits based on whether you have self-only (individual) or family coverage. Contribution limits change annually, and those age 55 and older are eligible to make additional catch-up contributions.

The annual contribution limits for 2020 are:

  • $3,550 for self-only coverage or $4,550 for self-only coverage if you are 55 or older and eligible to make a $1,000 catch-up contribution
  • $7,100 for family coverage or $8,100 for family coverage if you’re 55 or older, the primary insured on a qualifying family health plan, and eligible to make a $1,000 catch-up contribution

If your employer makes a contribution on your behalf, it is included in these annual limits -- so if your employer contributes $1,000 and you have self-only coverage, you are allowed to contribute only the remaining $2,550.

Contributions can be made until the tax deadline for any given year. This is normally April 15, or the next business day if April 15 falls on a weekend.

HSAs vs. FSAs

Health savings accounts differ from flexible spending accounts, which are also used to pay for medical expenses with pre-tax funds. The key differences include the following:

  • FSAs are open to anyone whose employer offers them and are not restricted to people with high-deductible health plans.
  • Money contributed to a FSA generally must be used in the year the money is contributed, while HSA funds can grow and be withdrawn at any time.
Did you know?

An HSA offers you a unique triple tax advantage that simply doesn't exist in other tax-deferred investment vehicles.

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Investing in a HSA

HSA funds can be invested -- the money does not have to remain in cash. Your investment options depend on where you hold your HSA account, but you’ll often have a selection of funds similar to what a 401(k) offers.

If you plan to use the money in an HSA within two to five years of contributing it, you should generally opt to leave it in cash or a cash equivalent so you aren’t subject to market fluctuations.

However, if you want to leave your money to grow to be used to cover healthcare costs later in life or as an additional retirement account, you should strongly consider investing the money so you can earn returns.

HSA distributions

HSA distributions can be made tax-free if used for qualifying medical purposes. The IRS provides a comprehensive list of expenses that qualify in Publication 502, but here's a quick list of some of the most common permissible uses:

  • Prescription medications
  • Nursing services
  • Long-term care services
  • Dental care
  • Eye care, including eye exams, glasses, and contact lenses
  • Psychiatric care
  • Surgical expenses
  • Fertility treatments
  • Chiropractic care
  • Medical equipment
  • Hearing aids

Once you reach age 65, you can withdraw money from your HSA for any reason without penalty -- however, you will be taxed at your ordinary tax rate if you don’t use it for a qualifying medical purpose. In other words, the withdrawal will be treated the same as when you take tax-deferred money out of a traditional IRA or 401(k).

How to open and fund an HSA

If you have a qualifying high-deductible health plan, your employer may offer an HSA. If this is the case, it's usually an attractive option -- especially if your employer makes any HSA contributions on your behalf.

Alternatively, there are several reputable financial institutions that offer HSAs. For example:

  • Lively offers HSAs with an FDIC-insured savings account option and the ability to invest your account funds through TD Ameritrade's (NASDAQ:AMTD) platform, which lets you choose virtually any stocks, bonds, ETFs, or mutual funds you want.
  • HSABank also offers HSAs with the option to invest through TD Ameritade’s platform or use a guided self-directed investment program that helps you put your money into low-fee mutual funds.

Although you can have multiple HSAs, the contribution limits apply in aggregate -- so you’ll need to make sure you keep tabs on the total amount invested in all of your accounts each year. You’ll also need to file a separate Form 8889 for each HSA. Because it can be complicated to do that, it often makes sense to stick to just maintaining one HSA -- either one your employer opens or your own.

The choice comes down to the best option for your goals. If your employer will contribute on your behalf to a specific HSA, the choice is generally easy. If not, it's a good idea to compare the features of the plan your employer offers directly (if any) with a few other options. For example, if you'd like to buy individual stocks in your HSA, you'll need to find an institution that allows that.

The bottom line on HSAs

HSAs give you the opportunity to set aside money so you can pay for medical care with pre-tax dollars. But because you can invest and grow these funds as well as hold them in cash, HSAs offer much more than just a way to save on medical care. If used as a long-term investment vehicle, your HSA account could save you tens of thousands on healthcare costs in retirement while reducing your tax bill in the meantime.